Banking in Transition Economies: Does Efficiency Require Instability?

Gorton, Gary, Winton, Andrew, Journal of Money, Credit & Banking

"Banking" and "instability" seem inherently intertwined. On one hand, a well-functioning, efficient banking system is essential to the workings of a capitalist economy: banks direct savings to investment opportunities when they choose a portfolio; they are an important part of the corporate governance system since they monitor firm managers; they provide a medium of exchange through the issuance of demand deposits and the associated payments and clearing systems. On the other hand, information asymmetries and banks' highly leveraged nature may lead to bank failures or system-wide panics, and such crises can be very costly because of externalities. Even advanced economies experience widespread and costly problems with banks; a current example is that of Japan's banks, where the latest official estimate puts problem loans at 77 trillion yen, or roughly 15 percent of GDP (see "Details, Details," Economist, January 17, 1998). Emerging economies also experience regular and costly banking crises. For example, in Chile in the 1980s bad loans accounted for 45 percent of GDP; losses from Venezuela's 1994 crisis are estimated at 16 percent of GDP.(1)

To varying degrees, the transition economies of Eastern Europe have taken measures to privatize their banking systems so as to improve their operating efficiency. However, the movement toward privatization has gone hand in hand with increased instability; virtually every transition economy has had some sort of banking crisis. Highlights include the crisis in Bulgaria resulting in nonperforming loans exceeding 60 percent of assets; in Estonia in 1992 insolvent banks had 47 percent of the deposits in the banking system; in Hungary in 1993, eight banks were found to be insolvent, totaling 25 percent of the total assets in the banking system; in Latvia in 1995 the central bank took over the largest private commercial bank after it suffered losses in the range of $50-$100 million (see Caprio and Klingebiel 1995). Further instability seems likely.

Because banks are now owned by private agents rather than the government with its deep pockets, and because transition economies inherit a large overhang of weak loans, privatization inevitably invites instability--some banks will fail. Also, private bank owners may choose a level of risk that is at odds with the socially optimal choice, so there is concern that too many banks will fail. As a result, the issue of banking system stability in transition economies has received a great deal of attention. Nevertheless, banking system efficiency is also important, and there is evidence that banking systems in transition economies are not only unstable but inefficient as well. In comparison to developed countries, the volume of credit creation in transition economies is generally too small, especially since capital market alternatives often do not really exist. Also, banks continue to direct funds to former state-owned enterprises (SOEs), despite the fact that many of these SOEs are inefficient. Finally, these banking systems are inefficient in providing transactions media and payments system and clearing services.

Given the instability and inefficiency of banking systems in transition economies, many basic questions about bank regulation and institutional design remain unanswered or in flux: what bank capital requirements are appropriate, whether free entry into banking should be allowed, etc. Nevertheless, at the root of these immediate policy questions lies a more basic issue: the combination of instability and inefficiency may reflect the difficulties of a transition from a command economy to a capitalist system, but it may also be the result of misguided policies that emphasize bank stability over efficiency--policies that ironically may make the banking system even more unstable. The underlying issue is whether it is possible to simultaneously achieve the goals of stability and efficiency for a transition economy's banking system; until this is resolved, it is difficult to answer the other questions. …

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